[MUSIC PLAYING] Welcome to Trade Ideas.
I'm Jake Merl sitting down with Michael Purves, Chief Market Strategist and Head of Derivatives
Strategy at Weeden.
Michael, it's great to have you back on the show.
And great to be here.
So with the S&P trading near all time highs, what opportunities in the markets are you
looking at right now?
Well, I think it's pretty hard right now to be an enthusiastic bull here.
We've seen a tremendous, a vicious rally from the December 24 lows.
You can make a great case for valuation reexpansion back in December.
You can't make that case anymore.
We're halfway through earnings season.
Earnings have come in really pretty nicely.
I'm not surprised by any of that.
But the question is is to really get through 3,000 here in the S&P 500 and onwards and
upwards, you're going to really need some increased growth.
Meanwhile, there's a backdrop that the European and Chinese economic condition continues to
be problematic.
And that could trigger a real upward boost in the dollar if that data continues to be
weak.
So there's a real risk here against a backdrop of we've added on two PE points just in three
months.
That's a very aggressive rally.
But having said all that, I do think there are interesting opportunities that set up
for good tactical trades, both on the long and the short side.
And again, I'm talking really at the sector level, not at the single stock level.
So which sectors are you most interested in?
Well, I'll tell you the thing that I have been constructive on on the long side has
been the banks, the XLF ETF.
And I think to explain that, there's sort of two primary factors that have been driven
that thesis, one of which was extreme relative valuation.
And I think the way I like to couch that is that look at the tech sector, the XLK ETF,
relative to the financial sector.
In this case, I'm using the XLF.
When you look at that price ratio, that's been blown out to 25-year extremes.
I mean, there's only been one time we've ever seen that price ratio higher.
That was in 2000, back when, of course, tech stocks were going to the moon.
You saw a very elevated ratio back in 2008 for very different reasons, not because of
tech doing so well, but because banks were being destroyed thanks to the great financial
crisis.
When you look at relative valuation between those two sectors, that has also, as you would
expect, really been heavily, heavily distorted.
And I went back and back tested it, and you can see that every time that that has set
up, it makes, actually, a really good long opportunity for the banks.
You can measure relative to TAC, relative to the broader S&P 500.
But that usually sets up a really nice signal.
So that's one factor here.
The second factor is that what happened in late Q4 was this concept of obviously very
severe equity market volatility, and then the Fed establishing its pivot, a process
that started in November into December and really got cemented in January.
And it kind of reinforced in the March FOMC.
And you can tell in the money markets that you just have to look at the eurodollar curve
or the Fed funds curve at 12 months.
They're speaking aggressively and loudly that the Fed is-- if anything is going to be cutting
this year.
It's kind of ironic that just back in September and early October, we were worried about too
many hikes and Powell hiking us into a recession.
Now that narrative has done a complete 180.
It's my view here-- and this is a bit of a market call on rates-- but it's been my view
that actually, there's a lot of reasons the back end of the curve will see higher yields
in the next several weeks here.
And that's been sort of slowly edging higher here.
There's a few reasons why I've had that view, one of which is that the inflation condition
domestically certainly hasn't been one of inflation momentum.
But it hasn't been one of contraction the way you had in 2015 and '16, when you actually
had negative CPI prints.
It's a much more stable floor.
Again, in prior discussions I've done on Real Vision, I've laid out this case that structural
disinflation is the defining feature of today's equity market.
And you have to recognize that, that the Fed's job of managing upside inflation risk is just
radically different than it was 25 years ago.
And you have to understand that and all that.
Having said that, that doesn't mean that there's not a reasonably firm floor for a lot of this
inflation data.
If you look at the break even inflation rates, the spread between tips and nominal yields
in the markets, those have been climbing from the lows up to basically 2%.
Where were they in September?
2.2.
You look at inflation break over and throughout the eurozone, and even Japan, those have even
started bouncing up a bit higher as well.
So I just don't think there's a clear case for the Fed to make a rate cut here unless
there's an out-of-consensus, out-of-expectation view that there's some really bad economic
data coming domestically-- and I certainly don't see that, and I think most would say
that would be a pretty much of a surprise.
So I think ultimately, the money market curves-- and it's really interesting if you plot out
the 10-year nominal yield with the money market curves since October, it's been tick for tick.
The 10-year yield is typically a bit more complicated in terms of what's driving it.
That contraction from 3.1 down to 2.5 has been really all about nothing but the Fed's
hiking trajectory, or the expectation of the Fed's hiking trajectory.
So my view is that if the money markets actually come up to where the Fed's dots are, the Fed
push pause button condition, that could easily add on another 20, 25, 30 basis points to
the back end, to the 10-year.
And that's going to help re-steepen those yield curves, whether you're looking at three
months to five year two to tens and so forth.
And that's going to help that backdrop of earnings for the big money center banks.
I do want to make an important point here, which is that I'm not excited about the earnings
stream coming out of the big banks.
This is not like some new, exciting, oh my god, there's going to be some massive upside
surprise to earnings.
But has that group of banks been able to generate reasonably stable, reasonably high quality
earnings growth through a lot of different yield curve conditions over the last four
or five years?
The answer is yes.
And they kind of just sort of keep grinding on.
So when you have extreme valuation coupled with a pretty stable earnings profile, but
with a little bit of a kicker that these yield curves are going to re-steepen and that not
all is destroyed for banks, I think that sets up a good condition to be long banks.
Now you've seen my notes from earlier, and I was recommending XLF calls in June, and
I've rolled those up twice now and taken profits.
I still think there's room there.
I'm not ready to do yet a third trade on the option side, but I think certainly if you're
in equities and you want to overweight XLF, it's around $28 right now.
I think you could see that grind up to $29 or $30 over the next three months there.
And at some point I'll probably re-enter in a third bullish trade through a call option.
And what would you say is the biggest risk to this thesis?
I think the biggest risk is that those yield curves get back into that negative territory
again, or that there's some real negative announcements.
But I think this is a pretty-- it may not be one of these things that's like going to
make your year type of trades.
But is it a good, solid place to put money when the market's just put in fresh highs?
Valuation is tough to trade, but when it gets extremely distorted, I look at it as a really
key factor because there usually is some renormalization of that.
So for the end of the second quarter type of frame, I think it's a good place to keep
some money.
Look, obviously there's big market risk that can happen here, and that will drag down all
these things.
But given how pounded these stocks got back in Q4 and into the early part of this year,
it's been fine.
And you know, they got through the earnings season.
Basically, these ugly ducklings came through reasonably good.
I think, also, it's important to realize that their net interest margins for the big banks,
they haven't collapsed through conditions over the last two years when the yield curves
kept flattening and going even in negative territory in some instances.
So this whole idea that oh my god, these banks will never be able to see this fantastic acceleration
of earnings.
Well, that's maybe true, but that doesn't mean, actually, they'll be losing money.
I think it's important to recognize, again, that these guys have been putting-- you just
look at their numbers on an aggregate basis-- they have been putting in decent enough earnings
growth.
So do you think the yield curve has bottomed and will start steepening altogether?
Or is this just a short-term tactical move?
My basic condition for the yield curves is that they're over the-- and this is a little
bit longer time frame than just Q2, say, over the next 12, 24 months-- is that I think we're
really in a different kind of condition here where they're really range bound.
Some of them will go a little bit negative again.
Some of them could re-steepen.
Picking on the two tens, could that get up to 50 basis points?
Sure.
And then could it go back down to zero?
Sure.
Is it gonna really signal the end of the cycle?
I don't think so.
I've talked with your colleagues about that in past interviews.
I really think it's a very different condition given this role of structural disinflation
and, of course, central banking and how that's weighing on the back end, and the relative
pace of normalization of the front end versus the back end.
And I think it's also important to point out that the banks have actually had some very
bad performance when the yield curves were very robust.
You go back a few years here.
So I think it's just important to clarify some of the noise and realize that you're
buying these giant banks' franchises.
They're post all the great financial fines that were being assaulted on them.
They're not the sexiest investment out there, but for a condition right now, I think they're
very solid.
So in addition to the financials, are there any other sectors you're looking at right
now?
Well, there's sort of an inverse, if you will, of the financials.
And I've been out there pounding the desk on the short utility trade here.
It's the same factors, basically.
Rather than valuation get super cheap, as it did with banks, it got super rich for the
utilities.
Why?
Because for volatility people go into defenses, and coupled with the fact that utilities,
as high paying dividend entities with the Fed pivot, with that 60, 70 basis point contraction
in the 10 year, they became extraordinarily loved, over loved.
And so just in the same way that I like long banks, I'm short utilities because A, I think
you can go back and back test it, but every time that the relative valuation of utilities
to the S&P 500 has become this elevated, it sets up a good 10%, 12%, 15% correction.
You look at the dividend spread between utilities and the S&P 500 dividend.
That spread, every time it got this narrow because the valuation got so strong on utilities,
it sets up a good tactical move downwards.
Look, you know if the VIX is at 1213, the markets are bid-- we're having risk-on conditions.
And you look at the VIX positioning, which has just hit record levels once again, you're
sort of saying why are utilities still this loved?
At some point, one of those two asset classes is wrong.
And in my view, I think the utilities, if the market continues to sort of bleed higher
here, people will be questioning why are they needing to own these utilities that don't
pay a compelling dividend given the valuation you have to pay for now.
And at the same time, if rates go higher, just as it's going to favor the banks, it's
going to disfavor the utilities.
So what's the technical setup look like right now?
Would now be a good time to go short?
Yeah.
You know, they've had a huge run over the last three or four weeks.
That chart started getting much more bearish.
I think it's going to start breaking down.
Again, it would be nice to see the 10 year get up to 2.6, 2.65, and then you're going
to start seeing people selling those things aggressively.
So I think there's a nice move here.
The XLU is a liquid ETFs that tracks the utilities.
And I think that is really given to easily a $2, maybe $3 move lower by the end of the
second quarter.
And so do you recommend shorting the ETF, or is there an options trade you suggest?
Well, the way I like it-- because I do think there's going to be a quick little break lower
here at some point in the next couple of months-- right now I like the regular June 57 strike
put options.
Right now they can be had for about $0.68.
And the ETF is right now at about $58 and a little bit higher.
And would you have a stop loss, or is it just the premiium you pay is the Risk
Yeah.
The premium is-- for a simple option trade like this, I think you just have to assume
that if you're wrong-- and you can be wrong not just on direction, but the timing of the
move, or not getting enough of the move fast enough.
So the premium, that $0.68 can vanish quickly.
So if you're using options, just recognize that.
But at the same time, there's a lot of leverage there.
So if you get a $3, $4 move, those options are going to balloon in value really fast.
And that's where you also have to be disciplined with profit taking and managing your option
position.
Well, Michael, that was great.
Thanks so much for joining us.
Thanks for having me.
So Michael is bearish on utilities.
Specifically, he suggests buying the June 21 57 strike put option on utilities select
sector SPDR ETF, ticker symbol XLU, for approximately $0.68.
He suggests taking profits if the option doubles in price.
In addition, Michael suggests overweight financials.
That was Michael Purves of Weeden, and for Real Vision, I'm Jake Merl.
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